The Big Idea
After Jackson Hole, a better market
Steven Abrahams | August 26, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Now that Fed Chair Powell has spoken at Jackson Hole, a big piece of risk has come out of the markets. Powell and the markets had looked into the future all summer and seen different things, and the difference inevitably would need to get resolved. Powell had seen a Fed pushing rates higher and keeping them there until inflation tracked toward 2%. The market expected tightening into early next year and then an ease. After Jackson Hole, the Fed and the markets are more closely aligned. Volatility should trend down in coming months. Risk should get a bid.
The Jackson Hole speech should largely resolve the summer tug-o-war between two camps in the market—one convinced the Fed will fight persistent inflation at all costs, and another convinced the Fed will pull up short if growth slows too much. Powell cast his lot with the inflation fighters. The market seemed to anticipate Powell all week long, repricing rates higher. With the speech done, the market has priced one more measure of Fed commitment to getting rates up and inflation down. At this point, the Fed and the markets seem to broadly agree on the likely path of the economy and policy and on the known unknowns.
The Fed and most investors broadly agree the economy is cooling, even though the signal is noisy. Initial estimates show real GDP dropped in the first half of the year, and the housing market is coming off the boil with existing home sales and new home sales below pre-pandemic marks. Home prices are slipping in some markets. But bank loan demand is strong. And a tight labor market and momentum in the cost of housing imply the economy has not cooled enough to put inflation on a clear path to 2%.
The implied path of fed funds after the Jackson Hole speech show fund peaking at 3.75% next May and only declining 25 bp to the end of 2023. That is a change from the start of August, for instance, where implied funds peaked around 3.25% and then dropped 50 bp through 2023. The dots after the next FOMC on September 21 could add some new tension to market pricing, but Powell’s comment at Jackson Hole about median fed funds running slightly below 4% through 2023 signal that at least his current thinking is not far from market pricing.
The Fed and the market also broadly agree that the economy is tracking toward recession. The Fed frames it as growth below trend, and the market puts it in terms of probabilities (Exhibit 1). But in July, long before Jackson Hole, informal consensus saw the Fed cycle ending in recession.
Exhibit 1: Consensus sees steadily rising odds of recession in the next year
The market and likely the Fed also see recession as mild in contrast to the abrupt recessions that followed the bursting of the Internet bubble in 2001, the Global Financial Crisis of 2008 or the onset of pandemic in March 2020. There are solid grounds for this. Consumer balance sheets are strong, although delinquencies in subprime auto lending have started to tick up. Corporate balance sheets are strong, although the weakest pockets of leveraged lending have seen borrower revenue growth slow quickly or even go negative. The banking system is well capitalized and liquid. This gives the economy some cushion to manage through recession.
The market also seems to see the known unknowns—low probability, high impact events that could create upside or downside from the consensus priced into the current market. The more apparent ones would relieve or reinforce supply pressures that are beyond the ability of the Fed to control. Examples for rates and credit:
- Upside from a rapid drop in headline and core CPI
- Upside from de-escalation of Russia-Ukraine
- Downside if Russia-Ukraine destabilizes Europe
- Downside from escalation of China-Taiwan
With these things largely priced into the market after Jackson Hole, the investing environment should look much more manageable than it has for much of the summer. There still is more work to do on the path of inflation, but at least the Fed’s response to inflation is clear. Rates and spreads should stabilize. Relative value should be easier to identify. Liquidity should improve.
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The view in rates
The 2-year note closed Friday at 3.40%, up 17 bp from a week ago. It is getting closer to fair value. The 10-year note closed toward the wide end of fair value at 3.04%. The 2-year rate should go above 3.50% as the market begins to appreciate a Fed more concerned about inflation than recession. Fair value at 10-year and longer maturities still looks solidly in the neighborhood of 2.50%, and that should steadily draw 10-year yields lower. But the possibility of a sustained fight with inflation may require compensation above fair value even in long maturities. The 2s10s curve looks likely to invert by around 70 bp before Fed tightening is over.
Fed RRP balances closed Friday at $2.18 trillion, solidly in the range since mid-June. Yields on Treasury bills into early October continue to trade below the current 2.30% rate on RRP cash. Money market funds have little alternative but to put proceeds into RRP.
Settings on 3-month LIBOR have closed Friday at 304 bp, wider by 6 bp on the week. Setting on 3-month term SOFR closed Friday at 291 bp, wider by 13 bp.
Breakeven 10-year inflation finished the week at 258 bp, up 3 bp from a week before. The 10-year real rate finished the week at 46 bp, higher by 4 bp.
The Treasury yield curve has finished its most recent session with 2s10s at -36 bp, more inverted by 10 bp on the week. The 5s30s finished the most recent session at 1 bp, flatter by 11 bp on the week.
The view in spreads
Jackson Hole has helped resolve the disconnect between Fed rhetoric on continued tightening and the easier path of fed funds implied in forward rates through most of the summer. Volatility should start to come down more reliably and spread markets should like it. Both MBS and credit have generally tightened since July with a brief interruption in August. MBS outperformed credit into August before becoming tactically rich. As the Fed tightens and growth slows, MBS should start outperforming again. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields finished the most recent session at 136 bp, wider by 4 bp on the week. Par 30-year MBS OAS finished the week at 28 bp, wider by 6 bp on the week. Investment grade cash credit spreads have tightened on the week by 3 bp.
The view in credit
Credit fundamentals have started to soften with the weakest credits showing slower revenue growth so far in 2022, declining free operating cash flow and less cash on the balance sheet. Ahead lays weaker demand, margin pressure, a soft housing market and various risks from Covid and supply interruptions. Inflation will land differently across different balance sheets. A recent New York Fed study argues inflation generally helps companies lift gross margins, although airlines and leisure may have an easier time passing through costs than healthcare, retail and restaurants. In leveraged loans, a higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low. But inflation and recession could take a toll and add credit risk to consumer balance sheets.
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